NET NEUTRALITY COURT FIGHT OPPORTUNITIES AND RISKS

PAUL GLENCHUR | MAY 5, 2016

HEDGEYE 2

DISCLAIMER Hedgeye Risk Management is a registered investment advisor, registered with the State of Connecticut. Hedgeye Risk Management is not a broker dealer and does not provide investment advice for individuals. This research does not constitute an offer to sell, or a solicitation of an offer to buy any security. This research is presented without regard to individual investment preferences or risk parameters; it is general information and does not constitute specific investment advice. This presentation is based on information from sources believed to be reliable. Hedgeye Risk Management is not responsible for errors, inaccuracies or omissions of information. The opinions and conclusions contained in this report are those of Hedgeye Risk Management, and are intended solely for the use of Hedgeye Risk Management’s clients and subscribers. In reaching these opinions and conclusions, Hedgeye Risk Management and its employees have relied upon research conducted by Hedgeye Risk Management’s employees, which is based upon sources considered credible and reliable within the industry. Hedgeye Risk Management is not responsible for the validity or authenticity of the information upon which it has relied.

TERMS OF USE This report is intended solely for the use of its recipient. Re-distribution or republication of this report and its contents are prohibited. For more details please refer to the appropriate sections of the Hedgeye Services Agreement and the Terms of Use at www.hedgeye.com

DISCLAIMER

PLEASE SUBMIT QUESTIONS* TO

QA@HEDGEYE.COM

*ANSWERED AT THE END OF THE CALL

HEDGEYE 4

COURT DECISION DUE ANY TIME BROADBAND PROVIDERS CHALLENGING FCC RULES

The case, USTA v. FCC, was argued before the U.S. Court of Appeals for the DC Circuit, the same court that rejected the last version of the FCC’s net neutrality rules (Verizon v. FCC).

In response to the Verizon decision, the Commission imposed tougher rules on ISPs, reclassifying broadband Internet access as a telecom service subject to common carrier regulation (Title II of the Communications Act). These rules are now challenged.

Oral arguments were held in early December. There is no deadline for decision, but sufficient time has passed for a ruling to issue at any time. Three judges (Judges David Tatel, Sri Srinivasan and Stephen Williams) will decide the case and multiple written opinions are possible.

PRIMARY TAKEAWAYS

HEDGEYE 6

• If court rejects wireless common carrier regulation:

– Upstream monetization opportunities are enhanced, including sponsored data plans

– Paid Prioritization not strictly prohibited

– Greater operational flexibility overall for wireless broadband providers (T, VZ, TMUS, S, USM)

POTENTIAL BOOST FOR WIRELESS?

HEDGEYE 7

• Risk for Facebook (FB), Amazon (AMZN), Microsoft (MSFT), Netflix (NFLX), Dish Network (DISH) and other upstream content and application providers

• Revenue sharing via sponsored data

• Commercial agreements for paid prioritization

• Potential interconnection fees

UNCERTAINTY FOR EDGE PROVIDERS?

HEDGEYE 8

• Likely that Title II common carrier treatment holds for cable and telco wired broadband (CMCSA, CHTR, CVC, T, VZ, CTL).

• Broadband services must be just and reasonably priced; no unreasonable discrimination.

• “General Conduct” standard: ISP cannot unreasonably interfere with ability to reach user or subscriber.

STATUS QUO FOR CABLE AND TELCOS?

FCC RULES AND COURT CASE

HEDGEYE 10

FCC NET NEUTRALITY RULES THE BASIC ISP RESTRICTIONS (WIRED AND WIRELESS)

● No traffic blocking

● No paid prioritization

● No traffic throttling

● General Conduct Standard

HEDGEYE 11

• Common carrier means carry the traffic of all requesting entities at roughly the same price

• Key to enforce “no blocking” and “no paid prioritization”

• Verizon v. FCC (DC Circuit): Absent common carrier regulation, cannot force carriage of data at zero cost for edge providers.

COMMON CARRIER REGULATION DISFAVORED

HEDGEYE 12

• Common carrier utility regulation limits operating flexibility and risks price regulation of broadband providers.

• Initial FCC plan eschewed common carrier treatment to enforce net neutrality.

• President Obama publicly backed Title II regulation, forcing FCC’s hand. Common carrier regulation imposed by 3-2 partisan vote.

TITLE II “NUCLEAR OPTION”

HEDGEYE 13

• In USTA v. FCC, cable operators, telcos and wireless carriers contend the FCC lacks legal authority to impose common carrier regulation on broadband services.

• Based on a prior Supreme Court ruling, the court probably leans toward upholding FCC power to impose Title II on cable operators and other wired broadband providers.

CABLE-TELCO CHALLENGE TO TITLE II

HEDGEYE 14

• The court will not judge the wisdom of regulating broadband as a common carrier service; the only question is whether the FCC’s order exceeds the agency’s legal powers.

• The Supreme Court, NCTA v. Brand X (2005), ruled the FCC had discretion to treat broadband as either a common carrier service or a less-regulated “information service.”

COURT NOT MAKING A POLICY CALL

PROBABLE JUDICIAL OUTCOMES

HEDGEYE 16

• Cable and telecom operators argue Brand X does not control this case

• Other provisions in the Communications Act, they argue, prohibit treating the Internet like a telecommunications service.

• Not a slam dunk for the FCC, but the judges seemed to support the FCC position that cable broadband can be classified as telecom

NOT A SLAM DUNK AGAINST CABLE

HEDGEYE 17

• The FCC struggled to justify treating wireless broadband as a common carrier service

• A specific statute says wireless service is not telecom unless it is connected to the “public switched network”

• Historically, the public switched network has been the plain old phone network, not the Internet.

WIRELESS IS A DIFFERENT STORY

HEDGEYE 18

• The FCC gets the benefit of the doubt if it interprets ambiguous laws in a reasonable way.

• But the judges appeared uncomfortable with the FCC’s new interpretation of the law.

• Also, the FCC is obligated to give notice of major rule changes and it never indicated the definition of “public switched network” could be changed to “the Internet.”

A LIKELY VICTORY FOR WIRELESS

HEDGEYE 19

• If the court invalidates common carrier regulation of wireless data, the FCC can rely on a separate provision of law – Section 706.

• Courts have recognized FCC Section 706 power to create net neutrality rules that promote innovation on the network edge that, in turn, stimulates network investment..

• But it is less rigorous than Title II regulation.

FCC’S FALLBACK REGULATION

HEDGEYE 20

• Although two courts (DC Circuit and 10th Circuit) say Section 706 is affirmative FCC power to push net neutrality, Congress did not intend this result.

• 6th Circuit may join other courts in recognizing Section 706 power.

• But ultimate Supreme Court review could upset FCC authority in long run.

SECTION 706 LEGAL WILD CARD

UPSIDE FOR WIRELESS CARRIERS

HEDGEYE 22

• Without obligation to carry all edge provider traffic for free, carriers can cut “commercially reasonable” deals with edge providers.

• Sponsored data and other agreements with upstream edge players become legally viable.

• Difficult to prohibit all traffic blocking and all paid prioritization.

• No rate regulation authority.

BENEFITS FOR WIRELESS CARRIERS

HEDGEYE 23

• Contrast common carrier test with standard for commercial reasonableness.

• No requirement to serve all comers on the same general terms.

• Instead, commercial reasonableness allows “individualized bargaining and discrimination in terms.” (DC Circuit, Cellco Partnership v. FCC, 2012).

“COMMERCIAL REASONABLENESS”

HEDGEYE 24

• FCC general conduct rule says ISP cannot interfere with or unreasonably disadvantage ability of edge provider to reach users.

• ISPs challenged the rule in court but judges did not seem to bite.

• Rule could be default restriction on wireless carriers if common carrier rule invalidated. Enforcement is case by case.

GENERAL CONDUCT STANDARD

HEDGEYE 25

• The FCC relies on common carrier classification to impose new privacy rules on ISPs (Section 222).

• If wireless broadband is not a common carrier service, new (proposed) privacy rules will not apply.

• Allows wireless ISPs more freedom to implement customer-contoured advertising models.

EXEMPTION FROM PRIVACY RULES

OTHER IMPACTS

HEDGEYE 27

• Ending common carrier regulation of wireless data opens up network monetization options.

• More freedom to adopt sponsored data or zero-rating programs otherwise deemed “discriminatory” under common carrier rules.

• Potential cost or revenue-sharing issues for edge players like Facebook or Netflix.

RISKS TO EDGE PROVIDERS

HEDGEYE 28

• Blocking mobile ads would be clear net neutrality violation under current rules.

• If common carrier rules lifted, blocking cannot be outright prohibited.

• Issue of network-level mobile ad blocking, ostensibly to help subscribers contain data usage, has emerged outside the U.S.

• Potential risk if traffic blocking allowed in U.S.

DISRUPTIVE RISK – AD BLOCKING

HEDGEYE 29

• FCC treats consumer Internet access as common carrier service, but did not classify interconnection with upstream edge content players as a telecom service.

• Interconnection is subsumed in duty to serve broadband subscribers under Title II.

• Court may reject this theory, creating higher interconnection cost risk to edge providers like Netflix (NFLX). Caveat: FCC’s CHTR merger conditions.

INTERCONNECTION RULE IN JEOPARDY

HEDGEYE 30

• Much like the change in the wireless data rule, the FCC likely gave inadequate notice of interconnection rule changes.

• Chairman Wheeler said interconnection would not be addressed in the net neutrality order.

• This could be another basis to kick the issue back to the FCC for a do-over.

INTERCONNECTION NOTICE PROBLEM

AFTERMATH OF COURT RULING

HEDGEYE 32

• We expect a mixed outcome from the court with good and bad news for all parties.

• Probable to likely: wireless common carrier and interconnection rules struck down.

• And Title II regulation of wired cable and telco broadband is upheld.

• Petition to Supreme Court seems likely.

WHAT HAPPENS NEXT?

HEDGEYE 33

• Projected timing suggests decision from DC Circuit is imminent.

• En Banc petition (asking for new hearing before all DC Circuit judges) is possible but not likely.

• Supreme Court petition in late summer and potential certiorari grant, hearing and decision in 2016-2017 Court term.

SUPREME COURT REVIEW

HEDGEYE 34

• FCC defeat on wireless net neutrality rules would put big hole in the net neutrality boat.

• Net Neutrality advocates could seek legislative deal to codify anti-blocking and paid prioritization measures.

• Republicans on Senate Commerce Committee back legislative, non-Title II solution.

• Potential for action in new Congress.

STARS ALIGN FOR CONGRESS TO ACT?

HEDGEYE 35

• White House support for net neutrality legislation would be critical.

• A supreme Court appeal could slow momentum for legislative solution.

• Uncertainty over judicial outcome offers best opportunity for compromise.

• Republican Trump Administration could appoint FCC majority that dilutes net neutrality policies.

ELECTION POLITICS MATTER

FOR MORE INFORMATION, CONTACT US AT:

SALES@HEDGEYE.COM (203) 562-6500